Game Theory

OLIGOPOLISTIC BEHAVIOR
 How Oligopolists Compete

In an oligopoly
 firms know that there are only a few large competitors;
 competitors take account of the effects of their actions
on the overall market.
To predict the outcome of such a market,
economists must model the interaction between
firms and so often use game theory or game
theoretic principles.
 Game theory
Each firm makes decisions that gives it highest
possible profit, given the action of its
competitors

Game theory analyses the way 2 or more players

choose actions or strategies that affect each
participant
 Strategic Behavior
Decisions that take into account the predicted
reactions of rival firms
 Interdependence of outcomes
Game Theory
 Players
 Strategies
 Payoff matrix
 Strategic Behavior
Types of Games
 Zero-sum games
 Nonzero-sum games
Nash Equilibrium
 Each player chooses a strategy that is optimal given the
strategy of the other player
 A strategy is dominant if it is optimal regardless of what
the other player does
 Game Theory: Setup

List of players: all the players are specified in

advance.
List of strategies: all the actions each player can
take.
Rules of play: who moves and when.
Information structure: who knows what when.
Payoffs: the amount each player gets for every
possible combination of the the players’ actions.
Dominant strategy: One player has best strategy
no matter what strategy other player follows
 Nash Equilibrium

A Nash Equilibrium, also known as Noncooperative

equilibrium, is the result when each player in a game
chooses the action that maximises his or her payoff
given the actions of other players, ignoring the
effects of his or her action on the payoffs received by
those other players.
 Advertising Example 1

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Advertising Example 1
What is the optimal strategy for Firm A if Firm B chooses to
advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Advertising Example 1
What is the optimal strategy for Firm A if Firm B chooses to
advertise?
If Firm A chooses to advertise, the payoff is 4. Otherwise,
the payoff is 2. The optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Advertising Example 1
What is the optimal strategy for Firm A if Firm B chooses
not to advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Advertising Example 1
What is the optimal strategy for Firm A if Firm B chooses
not to advertise?
If Firm A chooses to advertise, the payoff is 5. Otherwise,
the payoff is 3. Again, the optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Advertising Example 1
Regardless of what Firm B decides to do, the optimal
strategy for Firm A is to advertise. The dominant strategy
for Firm A is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Advertising Example 1
What is the optimal strategy for Firm B if Firm A chooses to
advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Advertising Example 1
What is the optimal strategy for Firm B if Firm A chooses to
advertise?
If Firm B chooses to advertise, the payoff is 3. Otherwise,
the payoff is 1. The optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Advertising Example 1
What is the optimal strategy for Firm B if Firm A chooses
not to advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Advertising Example 1
What is the optimal strategy for Firm B if Firm A chooses
not to advertise?
If Firm B chooses to advertise, the payoff is 5. Otherwise,
the payoff is 2. Again, the optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Advertising Example 1
Regardless of what Firm A decides to do, the optimal
strategy for Firm B is to advertise. The dominant strategy
for Firm B is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Advertising Example 1
The dominant strategy for Firm A is to advertise and the
dominant strategy for Firm B is to advertise. The Nash
equilibrium is for both firms to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Advertising Example 2

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Advertising Example 2
What is the optimal strategy for Firm A if Firm B chooses to
advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Advertising Example 2
What is the optimal strategy for Firm A if Firm B chooses to
advertise?
If Firm A chooses to advertise, the payoff is 4. Otherwise,
the payoff is 2. The optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Advertising Example 2
What is the optimal strategy for Firm A if Firm B chooses
not to advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Advertising Example 2
What is the optimal strategy for Firm A if Firm B chooses
not to advertise?
If Firm A chooses to advertise, the payoff is 5. Otherwise,
the payoff is 6. In this case, the optimal strategy is not to
advertise.
Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Advertising Example 2
The optimal strategy for Firm A depends on which strategy
is chosen by Firms B. Firm A does not have a dominant
strategy.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Advertising Example 2
What is the optimal strategy for Firm B if Firm A chooses to
advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Advertising Example 2
What is the optimal strategy for Firm B if Firm A chooses to
advertise?
If Firm B chooses to advertise, the payoff is 3. Otherwise,
the payoff is 1. The optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Advertising Example 2
What is the optimal strategy for Firm B if Firm A chooses
not to advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Advertising Example 2
What is the optimal strategy for Firm B if Firm A chooses
not to advertise?
If Firm B chooses to advertise, the payoff is 5. Otherwise,
the payoff is 2. Again, the optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Advertising Example 2
Regardless of what Firm A decides to do, the optimal
strategy for Firm B is to advertise. The dominant strategy
for Firm B is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Advertising Example 2
The dominant strategy for Firm B is to advertise. If Firm B
chooses to advertise, then the optimal strategy for Firm A
is to advertise. The Nash equilibrium is for both firms to
advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Prisoners’ Dilemma
Two suspects are arrested for armed robbery. They are
immediately separated. If convicted, they will get a term
of 10 years in prison. However, the evidence is not
sufficient to convict them of more than the crime of
possessing stolen goods, which carries a sentence of
only 1 year.
The suspects are told the following: If you confess and
your accomplice does not, you will go free. If you do not
confess and your accomplice does, you will get 10
years in prison. If you both confess, you will both get 5
years in prison.
 Prisoners’ Dilemma

Payoff Matrix (negative values)

Individual B
Confess Don't Confess
Confess (5, 5) (0, 10)
Individual A
Don't Confess (10, 0) (1, 1)
 Prisoners’ Dilemma

Dominant Strategy
Both Individuals Confess
(Nash Equilibrium)

Individual B
Confess Don't Confess
Confess (5, 5) (0, 10)
Individual A
Don't Confess (10, 0) (1, 1)
 Prisoners’ Dilemma

Application: Price Competition

Firm B
Low Price High Price
Low Price (2, 2) (5, 1)
Firm A
High Price (1, 5) (3, 3)
 Prisoners’ Dilemma

Application: Price Competition

Dominant Strategy: Low Price

Firm B
Low Price High Price
Low Price (2, 2) (5, 1)
Firm A
High Price (1, 5) (3, 3)
 Prisoners’ Dilemma

Application: Nonprice Competition

Firm B
Advertise Don't Advertise
Advertise (2, 2) (5, 1)
Firm A
Don't Advertise (1, 5) (3, 3)
 Prisoners’ Dilemma

Application: Nonprice Competition

Dominant Strategy: Advertise

Firm B
Advertise Don't Advertise
Advertise (2, 2) (5, 1)
Firm A
Don't Advertise (1, 5) (3, 3)
 Prisoners’ Dilemma

Application: Cartel Cheating

Firm B
Cheat Don't Cheat
Cheat (2, 2) (5, 1)
Firm A
Don't Cheat (1, 5) (3, 3)
 Prisoners’ Dilemma

Application: Cartel Cheating

Dominant Strategy: Cheat

Firm B
Cheat Don't Cheat
Cheat (2, 2) (5, 1)
Firm A
Don't Cheat (1, 5) (3, 3)
 Extensions of Game Theory

Repeated Games
 Many consecutive moves and countermoves by
each player
Tit-for-Tat Strategy
 Do to your opponent what your opponent has
just done to you
 Start off with cooperative behavior, but later do
what the other player did
 One shot game vs several round of games
 Extensions of Game Theory

Tit-for-Tat Strategy
 Stable set of players
 Small number of players
 Easy detection of cheating
 Stable demand and cost conditions
 Game repeated a large and uncertain number of
times
 Extensions of Game Theory

Threat Strategies
 Credibility
 Reputation
 Commitment
 Example: Entry deterrence
 Entry Deterrence

No Credible Entry Deterrence Firm B

Enter Do Not Enter
Low Price (4, -2) (6, 0)
Firm A
High Price (7, 2) (10, 0)

Credible Entry Deterrence Firm B

Enter Do Not Enter
Low Price (4, -2) (6, 0)
Firm A
High Price (3, 2) (8, 0)
 Entry Deterrence

No Credible Entry Deterrence Firm B

Enter Do Not Enter
Low Price (4, -2) (6, 0)
Firm A
High Price (7, 2) (10, 0)

Credible Entry Deterrence Firm B

Enter Do Not Enter
Low Price (4, -2) (6, 0)
Firm A
High Price (3, 2) (8, 0)
 International Competition

Boeing Versus Airbus Industrie

Airbus
Produce Don't Product
Produce (-10, -10) (100, 0)
Boeing
Don't Produce (0, 100) (0, 0)
 Sequential Games

Sequence of moves by rivals

Payoffs depend on entire sequence
Decision trees
 Decision nodes
 Branches (alternatives)
Solution by reverse induction
 From final decision to first decision
 Airbus and Boeing

Airbus Boeing

X
bo Jet $50 $50
Jum
B
Soni
c Cr $120 $100
uiser
A

Xbo Jet $0 $150

J um
B
Soni $0 $200
c Cr
uiser
 Airbus and Boeing

Airbus Boeing

X
bo Jet $50 $50
Jum
B Solution:
Soni
c Cr
uiser $120 $100 Airbus builds
A A380 and
X B
J um
Xbo Jet $0 $150
Boeing builds
Soni
c Cr $0 $200
Sonic Cruiser.
uiser